Competition and Adverse Selection in the Small-Dollar Loan Market: Overdraft versus Payday Credit

33 Pages Posted: 14 Sep 2009 Last revised: 22 Aug 2010

Brian Melzer

Federal Reserve Bank of Chicago

Donald P. Morgan

Federal Reserve Bank of New York

Date Written: December 1, 2009

Abstract

We find that competition from payday lenders leads depository institutions to raise overdraft fees and reduce the availability of “free” checking accounts. We attribute this rise in prices partly to adverse selection created by banks’ practice of charging a flat fee regardless of the overdraft amount — pricing that favors depositors prone to large overdrafts. Payday credit is priced per dollar borrowed, so when that option is available, depositors prone to small overdrafts switch. That selection works against banks; large overdrafts cost more to supply and, if depositors default, banks lose more, so prices rise. Consistent with this adverse selection hypothesis, we document that the average dollar amount per returned check at banks and other depository institutions increases when depositors have access to payday credit. Our findings illuminate competition and pricing frictions in the large, yet largely unstudied, small-dollar loan market.

Keywords: payday credit, overdraft credit, competition, adverse selection

JEL Classification: G21, G20, D14

Suggested Citation

Melzer, Brian and Morgan, Donald P., Competition and Adverse Selection in the Small-Dollar Loan Market: Overdraft versus Payday Credit (December 1, 2009). FRB of New York Staff Report No. 391. Available at SSRN: https://ssrn.com/abstract=1473204 or http://dx.doi.org/10.2139/ssrn.1473204

Brian Melzer

Federal Reserve Bank of Chicago ( email )

230 South LaSalle Street
Chicago, IL 60604
United States

Donald P. Morgan (Contact Author)

Federal Reserve Bank of New York ( email )

33 Liberty Street
Research Department
New York, NY 10045
United States
212-720-6573 (Phone)

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